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Last week's impressive rebound in stocks was more than just a head fake. I see seven reasons why the reversal was the start of a bullish move in stocks.
A safe way to play this turnaround is to get broad market exposure, using mutual funds and exchange-traded funds. For more oomph, build positions in companies that have the right characteristics for the slower economic growth ahead. To find those stocks, I picked the brains of several managers who have excellent records at diversified domestic-stock mutual funds.
Before we go there, here's why I see better times ahead for stocks:
Reason No. 1: The smart money is positioned for gains.
There are many ways to read the minds of the smart money on Wall Street. Jason Goepfert, who runs a great Web site called SentimenTrader.com that offers a cornucopia of investor-sentiment gauges, likes to look at what commercial traders are up to.
These are the savvy investors who hold huge positions in S&P 500 Index ($INX) futures contracts -- more than 1,000 contracts -- as part of a strategy to hedge risk. (Owners of futures contracts on a stock index have the right to take delivery of the underlying stocks in the future, at a predetermined price.)
- Talk back: Are you bullish or bearish right now?
People who own index futures as part of a hedging strategy are about as sophisticated as they come on Wall Street, Goepfert believes. Over the past seven years, this elite crowd has normally held sizable short positions in index futures. But these folks recently moved to a net long position in a way not seen in years. Several other smart-money measures indicate they are now about as bullish as they get, by Goepfert's calculations. This tells me the recent lows may have been a bottom for stocks.
Reason No. 2: Joe Six-Pack is in a panic.
Sadly, individual investors typically panic and sell their stocks at the bottom. (And I'm embarrassed to confess that I've done the same thing more than once.)
Now, the average investor is in a state of panic again -- suggesting stocks will go into a sustained uptrend from here. A recent American Association of Individual Investors survey of its members indicated they were in a state of depression about stocks. About 56% of them were bearish at the end of November, the highest level since 2000. The number of bulls was at near-record lows, too.
We also know average investors are extremely gloomy because they are shorting stocks in record amounts. Investors go short by borrowing stocks and selling them, hoping to replace them later at a lower price to pocket the difference. In mid-November, the percentage of New York Stock Exchange short positions held by the public was at 70%. That's the highest since 1943, according to Goepfert.
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Reason No. 3: Overall sentiment is extremely negative, too.
To be fair to those average Joes, they aren't the only ones who are bummed out about stocks. To measure the extent to which investors of all stripes hate stocks and favor bonds, Goepfert tracks the relative value of the two asset classes. On Nov. 26, investor preference for bonds over stocks came close to the highest level seen in 40 years. During the past four decades, there were 51 times investors hated stocks so much relative to bonds -- and 42 of those times, the S&P 500 Index was higher a month later, with an average gain of 3.1%.
Reason No. 4: Insiders are downright bullish.
Last week, for the sixth straight week, insider sentiment "remained firmly in bullish territory as buyers outnumbered sellers," according to InsiderScore.com. Buying by insiders, typically executives at the company in question, is a proven bullish indicator.
Reason No. 5: 'Tis the season to buy.
December is historically the best month to be in stocks. Since 1929, it's been an up month for the S&P 500 75% of the time. Each of the five times the S&P 500 lost more than 4% in November -- as it just did -- December was up, by an average of 5.6%.
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Will stocks soar or tank in 2008?It depends on China, says MSN Money's Jim Jubak. Optimists say China's economy will grow 11%, about the same as in 2007. Pessimists warn, however, that a slowing U.S. economy could whittle China's growth to 9% or even 7%. Pay attention to the pessimists. They all work in Beijing.
Reason No. 6: The Fed is not done.
Mary Miller, the director of fixed-income investing at T. Rowe Price, expects the Fed to cut short-term rates by another percentage point over the next several months. Historically, stocks do well in a rate-cutting environment.
Reason No. 7: The economy will be fine.
Sure, the housing and auto sectors are a mess. But they represent only 9% of the economy, though you might not know it because they seem to garner 95% of the attention of the financial media, says James Paulsen, an economist who is the chief investment strategist at Wells Capital Management. The rest of the economy has been growing nicely. Paulsen thinks most economists are too negative, and he doesn't expect a prolonged period of sub-2% economic growth.
Continued: How you should play the rebound
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